Improving Risk Governance Frameworks to Adapt to the New Banking Environment

How will risk governance at banks evolve in 10 years? To envision the future, consider the situation ten years ago. In 2005, the inception of the financial crisis was two years away and, on the surface, the fundamental economic structure had not changed that much. Looking more closely, however, the operational environment for banks had changed significantly. So, regulatory requirements, technology, and economic and industry forces may shape governance in a way we cannot yet imagine.

In Japan, there are more than 20,000 companies around today that were founded over 100 years ago. Although most are smalland medium-sized enterprises, the fact that so many firms have survived for so long is truly surprising. These long-established companies share two key characteristics – they tend to stick to their core business and accept the necessary reforms. These firms have been more flexible than their competitors who did not survive. The global banking industry has already seen drastic changes, which could continue at least for the next 10 years. So banks will need to adapt and accept reforms to not just survive, but also to better respond to upcoming environmental changes.

The global environment for banking is undergoing fundamental paradigm shifts amid slowly progressing structural changes in the world economy, with no sign of a turnaround – if anything, most of these trends are likely to continue for the next 10 years and pose serious challenges to the world’s banks.

Due to the financial crisis, numerous banking regulations have been introduced over the last few years, making the process of managing banks’ balance sheets more and more complicated. Maximizing revenue while managing risk and regulatory compliance has become increasingly difficult. Moreover, regulators now require that the management of all of an organization’s levels be consistent throughout. As more macro-prudential regulations pressure banks to make sure they do not become a threat to global financial stability, banks are finding that raising revenue simply by conducting an already increasingly risky business is becoming more difficult.

From a macroeconomic perspective, the amount of money flowing into the global financial markets owing to quantitative easing has ballooned to an unprecedented scale, as investors seek higher yields and new investment opportunities wherever they can be found. As a result, the world's financial markets have become more volatile, with a growing correlation among asset markets. In addition, the dramatic expansion of China’s economic presence has become one of the turbulent factors affecting global growth and the financial markets’ stability. Disinflation owing to low growth globally and the slump in commodity prices have also impacted the global economy.

These structural shifts have led to the emergence of new types of risks, which could be difficult to assess accurately with conventional risk management practices. Also, as banks shift away from their core businesses to seek profits, competition will intensify and they will feel even more pressure to maintain their profitability. However, banks will not be able to maintain revenue as easily as in the past. The large global banks in particular will have to address these paradigm shifts and carry out the necessary changes to survive.

The financial markets have also experienced structural changes in line with those in the global economy. With enormous amounts of money flowing into the global markets, bubbles have started forming in several asset categories, including equities and bonds, leading to strong concerns among market participants about the risk of price corrections (which tend to overshoot, causing wild ups and downs over short periods as well as more volatility), or a collapse. These risks are not limited to the short-term markets. For example, the sudden crash of the corporate bond market could badly hurt the financing conditions of firms, risking a credit crunch because of resulting liquidity tightening. A credit crunch would first affect firms with weaker liquidity even if they currently look safe or are free of credit risk (benefiting from monetary easing).

Because market risk can so easily lead to credit risk, banks should be especially alert to signs of market volatility or sudden changes in their operating environments. Huge capital inflows make emerging economies vulnerable because of the risk that investment cash flows could disappear at any moment if their economic indices go far below investors’ expectations. Such “disappointment risk” could lead to a credit crunch, a further decline in asset prices, exchange rate deterioration and further deterioration of the economy – a downward spiral particularly serious for emerging countries that rely on the issuance of external debt.

The rise in asset prices resulting from quantitative easing has lowered not only interest rates globally, but also risk premiums throughout the markets, which suggests that market participants have developed a strong risk appetite and are requiring less spread for the risks they are taking. As a result, the net interest margins – and therefore the profitability – of most banks in advanced economies have weakened.

The regulatory reforms following the financial crisis have achieved their main objective of preventing crises. Capital requirements have been raised significantly, making most banks more resistant to stress. Despite the emergence of several risks that could trigger global crises, a cascade of bank failures, such as during the financial crisis, is unlikely in the near future.

However, a new phenomenon has emerged, in which market segments such as shadowbanking, non-banks, and the fixed income markets (including funds and bonds) have assumed the role of banks in providing financing to the global economy. These segments are not subject to regulations as strict as those for the banking industry and have expanded very quickly, becoming an important source of financing – which has also led to concerns about potential price corrections driven by shocks in those segments.

Unfortunately, regulatory reform has also had some undesirable side effects. Because most large banks have downsized their trading operations, liquidity in some fixed income markets has declined considerably, greatly increasing price fluctuations in the government and corporate bond markets in advanced economies.

Another important side effect of quantitative easing is the “masking” of credit risk – that is, the flow of money has made some credit risk more difficult to discern, especially for low-credit-quality corporate firms. For example, global default rates have been very low, suggesting an almost complete lack of credit risk. However, default rates are low partly because the massive quantitative easing money has made financing conditions of corporate firms much easier and financial institutions have strengthened their risk appetite to take credit risks in those firms.

Because of the severe revenue environment, the large global banks have upped their risk appetite and aggressively loosened their lending criteria, as in the US leveraged loan market, where loan covenants have been relaxed significantly. With ample funds flowing into the market, low-credit-quality firms, which would otherwise have been pushed into distress, have instead benefited from vast amounts of available liquidity. In the event of a shock, these large amounts could quickly flow out of the market, causing serious liquidity issues for the low-credit-quality firms.

In addition to typical market or liquidity risks, credit risk could be triggered suddenly, causing extreme market volatility and transform into further risks, at least until quantitative easing ends and excess money flows out of the global market.

The significant tightening of banking regulations has improved banks’ financial strength and diminished the likelihood of similar crises. However, these banking regulations have also turned bank management into a much more complex process, with implications for the balance sheet management of the large global banks in particular.

1. Basel III capital regulations: require banks to hold a certain level of capital, including a variety of capital buffers.
2. The leverage ratio regulation: stipulates how banks manage their balance sheet size.
3. Liquidity regulations: mandates a certain level of liquidity, from both short- and long-term perspectives.
4. Interest Rate Risk in Banking Book (IRRBB): also requires that banks hold a certain level of capital.
5. The Total Loss Absorbing Capacity (TLAC) regulation: limits the amount of debt banks can hold on their books.

Once they are fully phased in, these regulations will constrain banks’ balance sheets from a variety of directions. In most cases, the regulations will work against the banks when they try to take on more risk to raise profits – the greater the risk, the worse the regulatory results. If banks want to achieve their revenue targets in line with the regulations, they will need to strike a very fine balance between aiming for higher profits and taking on more risk.

Figure 1. Moving toward a more self-directive risk governance framework

Source: Moody's Analytics

Regulations that are inconsistent or contradictory can be confusing. For example, a bank buying a government bond with a fixed interest rate would be positive for the liquidity regulations, but negative (because of the required concomitant increase in capital) for the leverage regulation. Moreover, because it is a fixed rate instrument, the IRRBB regulation would stipulate a higher capital requirement for the bank. Thus, determining if a certain business activity is good or bad from the perspective of regulatory compliance will become more complex.

Traditionally, in trying to achieve their revenue targets and minimize risk, banks have been able to comply with most regulations naturally in the course of business. However, with regulations becoming more complex, compliance is turning into a much more demanding task in itself, and banks will have to somehow reconcile three, not just two, competing factors: revenue growth, risk management, and regulatory compliance.

Over the next 10 years, the operating environment for banks will be quite different, especially for two reasons:

1. Macroeconomic and financial conditions: such as low growth, low interest rates, and excess money owing to quantitative easing; a volatile environment owing to rapid market changes; and an increase in hard-to-discern risks that can suddenly pop up.
2. Banking regulations: such as explicit strategies to maximize revenue, manage risk, and comply with regulation.

As a result, banks will have to make changes to their risk governance, revamping their governance frameworks by:

1. Creating an enterprise-wide framework to guide all employees and teams to achieve specific targets.
2. Developing tools to help management discern difficult-to-see risks and improve response speed.
3. Improving data management to enhance data quality.

Figure 2. Reforming risk governance: adapting to banking challenges

Source: Moody's Analytics

Because of tightening regulations and limited business opportunities, a bank will need to create a comprehensive business strategy that applies to all of its individual business segments. Running operations based on the revenue plans of individual business segments will not allow a bank to maximize group revenue, manage risk consistently, or thoroughly comply with regulations. This has been the main motivation for the introduction of Risk Appetite Frameworks, whereby banks set up overall business plans to accomplish these three tasks.

However, banks should focus more on proactively managing, rather than merely establishing, risk appetite, and making sure that all of the activities of their individual business segments are in sync. Given how quickly market conditions can change – and therefore how quickly financial risks can emerge – banks will need to be nimble and rapidly adapt to conditions as they evolve. And, ideally, each business segment will run as autonomously as possible but always in the direction of the overall strategy.

Additionally, frameworks should include incentives for business segments to meet specific targets. For example, if a bank’s goal is to minimize concentration risk in its credit portfolio, setting credit limits that reflect the economic capital or credit value-at-risk will be an effective tool to diminish portfolio concentration. The point is to set up a framework that all relevant employees can adhere to, to de-concentrate a portfolio. Or, if a bank is trying to achieve a better balance between risk and return, it can establish incentives to prioritize trades with a specific risk/return ratio; for example, by disseminating risk information on required spreads for loans or internal fund transfer pricing throughout the organization. These frameworks would guide all employees, so that all business activities would be directed toward achieving the specific targets.

In the areas where building such an autonomous framework proves difficult, firms can use other tools; in this case, enhancing their stress testing capabilities will be particularly important. If a bank can conduct stress tests quickly and flexibly enough, it will help correctly guide management.

Changes in the operating environment will make financial risks challenging to discern, and assessing potential risk using past data or traditional risk management tools will also be more difficult than in the past. For example, when oil prices declined sharply in early 2015, few banks knew how the drop in prices would affect industries other than the energy sector. Many banks tried to conduct an impact analysis to clarify the possible ripple effects of the drop in prices. What is more, no one could foresee how the drop would affect the financial markets. The plunge in oil prices itself was an unprecedented incident and considerable effort was needed to clarify the risk.

Banks will have to establish frameworks to more systematically identify emerging risks and provide early warning signs throughout their organizations. Banks will also have to develop sophisticated risk models to capture and quantify these risks. And all of a bank’s business segments should use the same risk models to ensure consistency.

With market conditions changing quickly and new types of risks emerging frequently, quickly obtaining accurate information throughout an organization will be critical, so having a first-rate management information system in place will be paramount. Moreover, that management information system should be the same for all of a group’s entities globally. A bank’s management team will need to respond rapidly to changes, and they will need the highest-quality data to make good decisions.

The banking industry will be affected by structural changes and will need to implement reforms in risk governance to adapt, requiring additional costs and effort. However, it is also true that "change is a chance." Only banks that can perform the necessary reforms in response to the changes will win the competition. The next ten years will definitely be an important turning point for large banks.